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How to profit from changes in Stock Market index composition?

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The National Stock Exchange ( NSE) has carried out an extensive exercise in index rebalancing that affects most of the indices it maintains. With effect from April 1, IndusInd Bank and NMDC enter the Nifty, while Wipro and Siemens were pulled out.

Siemens moves down to the Nifty Junior where Bajaj Financials, Tata Global and United Breweries are also being inducted. Biocon, GMR Infra and Torrent Power are being pulled out of the Junior.

There are multiple changes in other indices including the CNX 500, the CNX small caps and in sector indices like the realty, IT and service indices.

The changes have presumably been made on the basis of various factors such as liquidity, market cap, free- float, etc. The changes will also affect industry representation since the inductions and exclusions aren't from the same sectors.

However, the trader will be most interested in the potential impact on share prices of the stocks concerned.

In the broadest terms, a share that is "demoted" tends to lose market cap while a share that is "promoted" tends to gain market cap. One reason for this is simply that exchange- traded funds (ETFs) and index funds must rebalance portfolios to reflect index composition and weight. Other institutions also tend to follow suit and buy into the promoted stock if they are benchmarked to the stock. The demoted stock tends to lose value because of the obverse reason. ETFs and index funds must abandon it and other institutions often choose to reduce exposure as well.

A more subtle reason is that stocks are often promoted or demoted because they are trending up or down. IndusInd Bank is up over 26 per cent in the last year and 2.5 per cent in the last month. That is strong outperformance versus the major indices ( the Nifty is up about seven per cent), and versus its sector peers. NMDC has, however, been inducted for reasons other than performance. It is an attempt to give greater representation to the mining sector. In terms of price performance, it has lost ground in the last year, with market cap down around 17 per cent. Incidentally, Siemens is down 30 per cent in the last year, while Wipro is down one per cent.

There will be far more attention paid to the shares that have entered the Nifty than to shares that have entered other indices. This is just because there are more index funds tracking the Nifty and diversified funds benchmarked to the Nifty but there will be some attention paid to the entries/ exits from the Junior as well.

A trader who focuses on these stocks and goes long on the promoted ones should receive a return somewhat in excess of the market. Shorts on the demoted ones could be more risky and difficult to execute in terms of timing. But shorting the exiting stocks could also be a profitable exercise. 

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